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The Serial Backdoor Roth, A Tax-Free Retirement Kitty

If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a backdoor way. Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA. Is it worth it? “It’s a no-brainer if you have the cash to do it,” says Kevin Huston, an enrolled agent in Asheville, N.C. who has clients both young and old doing it to shore up their retirement savings. “It especially makes sense for people who are younger because they have all these years of tax-free growth,” he says.

Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty. The audience for backdoor Roths is a niche, appealing to those earning too much to contribute to Roths directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that “backdoor Roth” contributions represented about 2 percent of traditional IRA contributions in 2011. (Income restrictions on conversions were lifted starting Jan. 1, 2010, so anyone—regardless of income—can convert a traditional IRA to a Roth.)

Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA you don’t ever have to take money out, and when you do start taking money out, it’s all income-tax-free, including the earnings. By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.)

A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. And if you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings).

Here’s how the strategy is helping a couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. First, she’s maxing out on her company pre-tax 401(k) plan contributions—putting away the full $17,000 for 2012—her employer doesn’t offer a Roth 401(k) option. The couple told their tax advisor Huston they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed).

But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000 (his IRA is based on her earning and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA). Then they convert the IRAs into Roth IRAs. That sounds complicated but you can do it online, and it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.

There’s one big caveat to the backdoor Roth: the pro rata rule. When you calculate the taxes due on a conversion, you have to take into account all your IRA assets, not just the new $5,000 nondeductible IRA. For example, if you have a traditional IRA with $95,000 of money from a 401(k) rollover (the $95,000 contributions were made on a pre-tax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.

So when might it make sense to skip this whole exercise? Ronald Finkelstein, a CPA and lawyer with Marcum in Melville, N.Y., said he personally makes nondeductible IRA contributions each year and has considered doing a Roth conversion but passed because he has accumulated a large sum in a traditional IRA he opened 30 years ago when he had a newspaper route. Plus, he may retire to Florida, so paying the New York state tax bite wouldn’t make sense. “You have to do the calculations,” he warns.

But sometimes it can still make sense for folks, even older folks, with big traditional IRAs, to do the backdoor Roth. Another Huston client, a 68-year-old builder, does them as part of a holistic plan to get more of his net worth into tax-free accounts so he and his wife (and grandchildren) will have the accounts to tap as part of a tax diversification strategy. He just did a $6,000 backdoor Roth for the third year in a row. At the end of each calendar year, Huston and he look at his income and decide how much to convert from his traditional IRA too (one year it was $50,000; one year $25,000), keeping in mind what would push him into a higher tax bracket.

There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution too. How long should you wait to convert? “It’s a grey area,” says Robert Keebler, a CPA in Green Bay, Wisc. He suggests a waiting period of six months, although other advisors say to convert the next day to limit the tax bite on the conversion.

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The last day for Roth conversions for the 2011 tax year was Dec. 31, 2011. You can however still contribute to an IRA for the 2011 tax year through April 17, 2012 (reported on your 2011 tax return). And then do a Roth conversion by Dec. 31, 2012 (reported on your 2012 tax return).

Thanks. You wrote: “For example, if you have a traditional IRA with $95,000 of money from a 401(k) rollover (the $95,000 contributions were made on a pre-tax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.”

This makes sense and is clear – $4750 is taxable and $250 is not. What is not clear is that $95,000 is still in a Rollover IRA and $5000 in the Roth IRA. Suppose next year, I decided to convert the entire Rollover IRA to Roth IRA to simplify the matters. Intuitively, taxes would be due on $90,250 and not entire $95,000. How would this be handled? The trustee would distribute $95,000 that I would deposit in Roth IRA. Where would it be handled that 4750 is already taxed in the previous year?

This article could be me and my wife. I earned money while she was in school, now I’m a stay at home dad and she has enough to give us a MAGI that is too high for Roth.

My question is this: I have a lot of traditional IRA money. I want to convert her non-deductible IRA to Roth. Since I do not have a W2 and can only contribute because of married filing jointly, do my traditional IRA assets count for the pro-rata or is it just the funds in her name/ssn? Thank you.

Your IRAs are yours, and your wife’s are hers, (separate) for purpose of the pro rata rule on Roth conversions; in other words you don’t take into account the husband’s IRAs when calculating the conversion tax on a wife’s IRA conversion. Of course, if you both do taxable conversions that could impact your tax bracket on a joint return. Hope that helps.

Thank you so much. This helps a lot. So to clarify, she can convert her traditional account to Roth this year. Next year, and each subsequent year, she can contribute up to the maximum allowed and then convert over to Roth each year and we can leave my IRA alone or contribute non-deductible to the maximum allowed.

Question for Ashlea I’ve not been able to find the answer to…when you “roll-in” your pretax contributions and earnings into your company-sponsored 401k in an effort to separate them from your nondeductible contributions in your IRA (prior the Roth conversion), does the “roll-in” amount go towards your annual $17,500 401k contribution limit? In other words, after I do this, can I still contribute $17,500 separately from this roll-in transaction or not? Thanks!